Capital market frictions and conservative reporting: Evidence from short selling constraints

I use a natural experiment, Reg SHO, that relaxed short selling constraints on a random sample of U.S. stocks to study how capital market frictions affect conditional conservatism in financial reporting, defined as earnings reflecting bad news more quickly than good news. Since reducing short selling constraints increases the sensitivity of stock prices to bad news, managers may decrease conditional conservatism to delay the recognition of bad news in earnings. However, if equity investors anticipate this, then they may demand an increase in conditional conservatism such that there is no net effect. With a difference-in-differences design, I find that a decrease in short selling constraints causes a decrease in conditional conservatism. The result improves our understanding of how market regulation affects accounting choices and suggests that relaxing equity market frictions can have potentially negative consequences for financial reporting quality.